AS=AD for every commodity in the economy.......................
- Part of the Walrasian heritage.
- Two basic principles
- Optimizing behaviour on the part of individual entities in the presence of prices taken as given.
- Setting of prices so that, given this individual behaviour, S=D in each market.
- Three ways to include money:
- Overlapping generations - money is a device for accomplishing inter temporal reallocation of consumption - young people save, old people spend.
- Money in the utility function - lowest liquidity costs - particularly the question of whether money yields utility directly or indirectly through lower transaction costs.
- Cash-in-advance models - where cash is required to undertake transactions and this is a constraint rather than in the utility function.
- Firms maximise profits by choosing inputs and outputs subject to prices
- Consumers maximise utility from consumption subject to a budget constraint which is consumption = endowment + profits
- Equilibrium properties:
- Not unique as equations are homogenous (therefore can have multiples of the price level)
- Walras' Law defines the linear dependence among the n equations.
- Difference between temporary and full (Arrow-Debreu) equilibrium where all goods can be exchanged now via a set of futures markets and the implied future savings/investment decisions.
- As Keynes said saving although the abstinence from current consumption offers no signals for future consumption and thus has a depressing effect on employment.
- Problem with Arrow-Debreu system is there is no role for money.
- However, as a method for intertemporal transfers return-bearing assets are superior to money and argubably if an economy is of a finite duration then money will lose its ability to hold value.
- One problem with cash in advance is that it requires two constraints making it not obviously superior to a barter world (Clower dilemma). Though this is usually dealt with by 1. transaction costs & imperfect info 2. legal restrictions or social/institutional arrangements.